The Stock Market

If you're like most students, you probably don't think much or at all about the stock market. But maybe you should.

Why does the stock market matter to you? Because the stock market – and the whole broader arena of financial investing, really – will almost certainly shape what kind of life you're going to be able to lead. Where you'll be able to live. What kind of lifestyle you'll be able to afford. When (and even whether) you'll be able to retire someday.

Investing matters because it's how the poor become rich and how the rich become richer; they stop working for their money and allow their savings to do their work for them. Big shifts in the overall American (and world) economy over the past generation or two have made it harder and harder to get ahead just by working hard; nowadays, if you don't make some smart investments, you're going to have an incredibly tough time living the kind of life you want to lead on the basis of your wages or salary alone.

Some people like schlepping bricks their whole life. If that's you, great. If it's not… well, listen up.

What Is "The Stock Market"?

Imagine yourself strolling down the aisles of Safeway, looking for bargains on your groceries. But imagine that the price of a bunch of bananas – and everything else – changes its price every second or less. Also, if you want you can sell back your bananas as well as buying more of them. That's basically how a stock brokerage works: the brokerage is the store and the shoppers trading bananas are the investors who buy and sell stocks. In practice, most of the investors trying to profit in the banana trade won't end up doing any better than the entire market performs… but a lot people like to go shopping anyways. And by the way, if you string together all the grocery stores in the world, they comprise the stock market.

There are several different kinds of financial products you can invest in through your brokerage: stocks, bonds, and mutual funds are probably the most important of these.

Mutual Funds

A mutual fund is just a fancy name for a bunch of stocks, grouped together into one package to make it easier to buy and sell. Imagine that we're still in the produce section; most folks want a balanced diet of investing but need fiber from all kinds of sources. Mutual funds are a way to buy fruit salad (a whole bunch of stocks bundled together) rather than just bananas (i.e., one individual stock).

For rich people, mutual funds are a simple convenience. In one shot, they can "buy exposure" to a wide range of securities. But for the average Joe, mutual funds provide a unique and irreplaceable service. To "buy diversity," most investors would need to purchase 75 to 200 different stocks. If they had to do that on their own, they'd have to buy $50-100,000 worth of securities at one time, or else pay a bunch of extra fees in "odd lot" penalties. (An odd lot is a purchase of securities smaller than some nice round number, usually 100 shares. The commission for a typical trade of 100 shares might be $50; to trade 4 shares also likely costs the same $50. The price per share of the commission on that odd lot trade will thus dwarf any investment gains the stock is likely to achieve over the next year or five.) Needless to say, most people don't have $50-100 grand lying around under the sofa cushions, so most people could never hope to build a diverse investment portfolio if they had to buy each stock one at a time.

Enter mutual funds. These aggregate large pools of investors' dollars to be able to buy a diverse basket of securities at "wholesale" prices. You can invest $1000 in a mutual fund and get the equivalent of fractional shares in hundreds of different stocks, all while paying relatively low fees.

For this reason, mutual funds are immensely popular. Most ordinary folks who invest a bit in the market – maybe in the form of a retirement account or college savings plan – will do so by buying mutual funds. So do your homework and invest wisely.

Stocks

But maybe you're really into bananas. Fruit salad is great, but everybody is into fruit salad. Your investment in fruit salad will probably make you decent money, but it's not going to turn you into a millionaire by next year. But you just happen to have a hunch that papayas, in particular, are about to become the most profitable fruit in the produce section. So you might decide to buy shares in an individual stock in the papaya industry, hoping to beat the market – that is, to make more, faster, than you could by buying into the fruit salad of a mutual fund.

Now stocks, like the individual foods for sale at the grocery store, are not all created alike. You can eat a pound of watermelon and one thing is likely to happen; you can eat a pound of chocolate and another thing entirely is likely to happen; and you can eat a pound of prunes and a whole lot of something ugly is likely to happen.

So try not to put all your money in prunes.

Which stock is right for you depends on your appetite for risk and reward; the price of any particular stock at any particular time is set by our old friends supply and demand. Stocks which pay high dividends (that is, a promised payout in cash each quarter of the year) are generally considered lower-risk/lower-reward investments. They're thought to be a bit "safer," if probably less likely to explode in value. Meanwhile, stocks which trade at lofty multiples of earnings are regarded as "risky"; their value might continue shooting up, or it could come crashing back down.

So choose your investment in papayas carefully.

Bonds

In addition to stocks, you can buy bonds. What's the difference?

Basically, a stock is a share of ownership in a company. You buy one share of Google, you just bought one tiny slice of the ownership of Google.

A bond, meanwhile, is basically a loan from you to whomever issued the bond – some private company or government entity, usually. The price of the bond is the amount of the loan you're giving them; they will then promise to pay you back regular interest payments, plus eventually the full value of the loan when the bond reaches "maturity."

That means that bonds, in general, are less risky but also have less upside than stocks. Unless the company (or government) that issued the bond goes bankrupt, of course. Then things start to get risky and you might just lose your shirt.

What Sets the Price of Securities?

What determines how much any stock or bond costs? You surely already know the answer to this, friend; it's the same thing that sets the price for everything: supply and demand.

A whole bunch of investors share your view that papayas are the next big thing and want to get into the same company you do: demand for that stock rises and so does the price.

Some kind of bad news on the papaya front – new scientific research proves that papayas make you fat, oh noes! – causes investors to want to flee that industry: demand for the stock falls and the price starts to plummet.

Same thing for bonds: if investors get scared off by volatility in the stock market and want a safe bet in some highly rated bond, demand will increase and the price will, too. But if investors worry that some bond issuer is about to go bankrupt, making the bonds worthless, demand (and prices) will fall.

Elementary, my dear Watson.

But what factors will influence investors' views on which securities will remain in demand, and which won't? There are a whole bunch of metrics to consider: The company's earnings and profit margins. The price-to-earnings ratio – that is, a comparison of the stock price to the size of the company's business. The size of the stock's dividend, if any. The future growth potential (or the opposite) in whatever industry the stock is in. (Is it a good time to invest in the growth potential of green technology? Maybe. Is it a good time to invest in the growth potential of print newspapers? Probably not.)

Some Real Examples

Let's pick on Google for a minute. Google is the King of Search. It has very high profit margins… and a huge load of cash sitting on its balance sheet. So how do we know what a fair price is to pay for GOOG?

Well, as we said, the market value of a company is… whatever the market forces of supply and demand say it is. GOOG has often traded at around $500 per share. The country has roughly 320 million shares outstanding, so if you do the math (320 million x $500) you see that the market has priced the company's total value at something like $160 billion. Whoa.

But Google has enormous profitability. The company has about $32 billion in cash lying around (as of 2010) and no debt on its balance sheet. And it generates almost a billion dollars a month in cash profits. So if you subtract the $32 billion from the $160 billion, you get an "equity capitalization" of a little under $130 billion. If the company will earn $12 billion in the next year, that means that GOOG is trading at a price-to-earnings ratio of about 11x earnings.

If the company continues to grow at anything like the pace it has grown in the past, that's likely "cheap" – even at $500 a share. But if the company's growth slows down, there's also a long way for that price to fall. So would you say GOOG is worth the risk?

What about the Un-Google? GOOG is a great company in a vibrant industry with great profit margins and "free cash flow dynamics" – that is, the company has relatively low costs in infrastructure or capital expenses. But what about a company facing almost the opposite situation; an easy target is the auto industry.

The industry is "enjoying" little or no growth in the United States. Running huge auto plants is enormously expensive in terms of capital expenditures – keeping all that heavy machinery running isn't cheap. Old union contracts have locked in high labor costs and reduced flexibility in the way management can use its workers. It's not an accident that companies like GM and Chrysler almost went out of business in 2009 and had to be bailed out by the government.

So, do you want to buy stock in GM? It certainly looks like a risky bet… and it is. But – remember the magic of supply and demand here – it's possible that demand for GM stock will fall so low that it might start to look to you like a stock with upside. In 2010, somebody bought Newsweek magazine – a firm in another deeply troubled industry – for one dollar. He'll probably lose a ton more money… but if he can somehow turn things around, his upside is huge. Do you have the taste for risk that would lead you to invest in a dodgy industry like autos or print media? Or would you rather stick to Google?

Finally, what about those super-trendy stocks that explode into popularity and trade at seemingly unbelievable valuations. That is, some given company – let's call it shmoop.com, just for fun – goes public at $30 a share, having earned 70 cents a share the year before and with Wall Street analysts projecting that it will earn a dollar a share in the next year.

By three days after the IPO, though, investors just can't get enough Shmoop; the price of the stock has zoomed to $100 a share and the Wall Street Journal writes, "ZOMG! Shmoop Trades at 100x Earnings."

What's going on here? Why would investors invest at such a high multiple? Nobody in his right mind would pay $100 per share for only $1 in earnings, right? But what's happened here is that the market is pricing in higher expectations of the future. The buying public has fallen so in love with the CEO of Shmoop and with the wily founder's creative vision that they believe the company will, in fact, earn $3 a share next year and $10 a share the year after that. So in the world they imagine, Shmoop will really be trading at 10x earnings rather than 100x, making it a fabulous growth stock. That's their dream, anyway; it will be up to their friends at Shmoop to make it actually happen. If it does, those investors will have made a mint. If it doesn't… oops.

Some Final Basics

If you’re hunting for an investment, remember that not all stock is the same. There are two basic types of stock: common and preferred. Common stock grants not just partial ownership in a corporation, but also voting rights. Each share of common stock carries a vote that its owner may cast in the elections that select the board of directors. A sizable bloc of stock confers significant power in choosing the people who will govern the company. Preferred stock does not confer voting rights, but it does guarantee some sort of dividend. Common stock holders may not receive a dividend if the board of directors decides to re-invest all of the profits. Preferred stock holders are also closer to the front of the line if the corporation goes out of business. If the company goes broke, creditors and bond holders have first claim on the company’s assets; preferred stock holders come next.

Next, investors have to know where to buy the stock that they are looking for. Not all stocks are sold in the same place or in the same way. For starters, you don’t buy stock from the company itself—you buy it from a current owner of the stock—and a stock broker facilitates the exchange. The exchange may take place in a physical stock market—America’s largest and oldest are the New York Stock Exchange and the American Stock Exchange. But the nation’s fastest growing exchange is the National Association of Securities Dealers Automated Quotations or Nasdaq. There are also regionial exchanges in several cities that handle the stock of corporations in their area.

Nowadays, though, as far as you're concerned, it's all about the internet. You don't really care where your stock is listed, and you can almost certainly do all your trading from your laptop while wearing your pajamas. But if you don't want to lose your shirt (like that mixed metaphor there?), you'll probably want to have a strong sense of whether the market as a whole is rising or falling.

A bull market is a market in which prices are rising. In a bear market prices are falling. Generally, investors favor bull markets because they are “long” in a stock—that is, stock investors buy a stock with the expectation that it will rise in value so they can sell it for a profit. But is it also possible to “go short” or “sell short” and make money on a falling stock. (If you have never been able to pick a winner this is the niche you’ve been looking for.) When you sell short you borrow the stock from your broker with the agreement that you will return the same number of shares at a later date. You then sell the stock while its price is relatively high, wait for the price to fall, and then buy the stock and return it to your broker. Your profit lies in the difference between the price you sold the borrowed stock for and the price you pay in buying the stock that you return to your broker. You can make a lot of money that way... or lose it all. Probably not a game to be played by amateurs, to be honest.

Brokers can help you out in other ways as well. When you buy stock on margin, your broker lends you a portion of the purchase price. For example, you may be asked only to pay 10% of the total purchase price. Of course, your broker charges you interest on the money he lends you. And if the stock you buy falls in value, placing the money he lent you at risk, he will issue a margin call demanding that you deposit more money or securities into your margin account to protect him from losses.

You should also understand the various ways that you can hedge your bets or reduce your risks in the market. Options, for example, give you the opportunity to buy or sell a stock at a specified price during a limited period of time. When you buy a put option, you are buying the option of purchasing stock at the strike price during an agreed upon period of time. When you purchase a call option, you are buying the option of selling stock at the strike price during an agreed upon period of time. An option allows you to hedge your bets—lock in a certain price before it changes to your disadvantage. But you pay for this certainty. Your final gain or loss will include the price you pay for the option.

You can also reduce your risk by placing stop orders. These are standing orders with your broker stating that he should buy or sell stocks when they reach a certain price. For example, when you are long in a stock you might place a sell stop order telling your broker to dump the stock if the price falls to a certain point. If you are short in a stock, you would place a buy stop order telling your broker to buy the stock if it climbs to a certain price, so that you can cover your short without losing any more money.

Why It Matters Today

Investor Warren Buffett, the richest person in the world, has been called "The Oracle of Omaha."

A mailman who was putting $1000 each year into savings once asked him how to become a billionaire. "Live to 5000," Buffett said.

That's funny, but it points to a deeper truth. Lottery winners excepted, it takes time to build wealth. Hopefully not 5000 years, but the miracle of compounding interest means that small investments can really add up over a long period of time. (Or "multiply up," really.)

Over the course of the last century, the stock market has grown by an average rate of about 9% per year. Looking forward, a more realistic bet is that the stock market will grow 5% per year. With the reinvestment of compounding interest, that means you'd have been about to double your money about every eight years. At that rate, if you'd invested $1000 back in 1930, your investment would have grown to be worth more than $1 million in 2008.